FIG. 1 illustrates a Credit Default Swap, or “CDS,” which is a type of contract that is often used to hedge against the risk that a company 103 will default on a loan or some other financial obligation. A CDS involves a protection buyer 101 and a protection seller 102. Most commonly, the protection buyer 101 pays the protection seller 102 one or more fees, and the protection seller 102 pays the protection buyer 101 a notional amount if and only if a predefined credit event occurs. For example, assume protection buyer 101 makes a loan to company 103. If the protection buyer 101 desires to hedge against the risk that the company 103 will default on the loan, the protection buyer 101 may enter into a CDS with the protection seller 102. In this example, the CDS may be structured so that the protection buyer 101 agrees to pay the protection seller 102 one or more fees, and, in return, the protection seller 102 agrees to pay the protection buyer 101 a notional amount in the event that the company 103 defaults on the loan.
The protection buyer 101 and the protection seller 102 may assign their benefits and obligations under the CDS to another party. For example, the protection buyer 101 may assign to an assignee 104, for example, its obligation to pay the protection seller 102 the one or more fees and its benefit to receive the notional amount from the protection seller 102 in the event that the company 103 defaults. In this situation, the assignee 104 is obligated to pay the protection seller 102 the one or more fees, but would receive the notional amount from the protection seller 102 if the company 103 defaults. On the other hand, the protection seller 102 may assign to an assignee 105 its obligation to pay the notional amount and its benefit of receiving the one or more fees. If protection buyer 101 assigns to the assignee 104, and the protection seller 102 assigns to the assignee 105, the assignee 104 pays the one or more fees to the assignee 105, and the assignee 105 pays the assignee 104 the notional amount if the company 103 defaults.
Depending upon the perceived credit strength of the company 103, the assignee 104 will pay more or less money to the protection buyer 101 in order to step into the position of the protection buyer 101 in the CDS. Similarly, depending upon the perceived credit strength of the company 103, the assignee 105 will pay more or less money to the protection seller 102 in order to step into the position of the protection seller 102 in the CDS. Accordingly, the price at which other parties are willing to pay to enter into a CDS via assignment is an indicator of the perceived credit strength of the company 103.
The price that the assignee 104 is willing to pay to step into the position of the protection buyer 101 is referred to herein as a market value of the CDS. The market value of the CDS not only depends upon the perceived credit strength of the company 103, but also the duration of the CDS, referred to herein as the “tenor.” The tenor of the CDS is the amount of time that the protection seller 102 is obligated to pay the notional amount to the protection buyer 101 if the company 103 defaults. For example, if the CDS has a tenor of 3 years, the protection seller 102 is obligated to pay the amount to the protection buyer 101 if the company 103 defaults at any time within those three years. Accordingly, a longer tenor typically commands a higher market value, because a longer tenor provides a longer duration of protection against default for the protection buyer 101.
An illustration of the market value of a CDS versus time for the company 103 is shown, for example, at FIG. 2. A curve, such as the one in FIG. 2, which shows market value versus time of a CDS, is referred to herein as a “CDS curve.” As can be seen in FIG. 2, the market value of a CDS for the company 103 increases as the tenor increases.
Conventionally, CDS curves have been manually generated by traders involved in trading CDSs between parties, such as trading a CDS between the protection buyer 101 and the assignee 104. To continue with the example of FIG. 1, a trader who is actively involved in trading CDSs based upon the credit of the company 103 is aware of current market values of such CDSs. Assume that a trader just sold a CDS based upon the credit of the company 103 from the protection buyer 101 to the assignee 104 with a tenor of 1 year for $10. In this case, the trader would record the 1 year CDS price for the company 103 as $10, as shown, for example in FIG. 2. If the trader traded a 5-year CDS for $60, but not a 3-year, the trader may estimate the cost of the 3-year as being between $10 and $60. Accordingly, traders use their knowledge of the marketplace to create CDS curves, such as that shown in FIG. 2. Therefore, the accuracy of the CDS curve is dependent upon such knowledge. If a company has not had many CDSs traded for it, little or no market information exists from which to generate a CDS curve.
Accurate CDS curves are important for protection sellers because they are used by protection sellers to determine their overall risk position. In other words, CDS curves assist protection sellers in evaluating how much risk they are exposed to at any given time. If a protection seller is involved in many high risk CDSs, i.e., ones where the protection seller is likely to make a payout, the protection seller may decide that it should only enter into low risk CDSs for the time being or take other actions to hedge the increased risk.
Therefore, a need exists in the art for improved methods for generating accurate CDS curves.